Bissau Ltd. issued $ 4,000,000, 5-year, 8% convertible bonds at par. Bonds pay interest annually. Each $ 1,000 bond is convertible to 200 of Bissau's no par value common shares, which are currently trading at $ 25 each. The current market rate for similar non-convertible bonds is 10%. Assuming Bissau adheres to IFRS, the value to be recorded for the conversion option is
A) $ 0.
B) $ 5,000.
C) $ 100,000.
D) $ 303,267.

Question

Quizplus · Accepted Answer

Under IFRS, the conversion option of convertible bonds should be recognized as a debt-bundled equity instrument. The value of the conversion option should be determined at issuance and recognized as a component of equity.

To calculate the value of the conversion option, we first need to calculate the fair value of a non-convertible bond with similar terms. The annual interest payment on the bond is $ 320 ($ 4,000,000 × 8%) and the market rate of interest is 10%. Using the present value of a single amount formula, we can calculate the fair value of the bond to be $ 2,881,187.

Next, we need to calculate the intrinsic value of the conversion option. Since each bond is convertible to 200 common shares, the intrinsic value of the option is the excess of the market price of the common shares over the conversion price ($25 - $1,000/200 = $20). Therefore, the intrinsic value of the option is $ 4,000,000 × ($ 25 - $ 20) = $ 20,000,000.

The total value of the convertible bond is the sum of the fair value of the non-convertible bond and the intrinsic value of the conversion option, which is $ 2,881,187 + $ 20,000,000 = $ 22,881,187. The value of the conversion option to be recorded in equity is the difference between the total value of the bond and the face value of the bond, which is $ 22,881,187 - $ 4,000,000 = $ 18,881,187 or $303,267 per bond ($ 18,881,187 ÷ 62 bonds).